Real Estate: House of Cards or Dose of Reality?

Dear Friends-

Brace yourself. The headlines about the imminent implosion of the housing market are on the verge of getting really ugly. We’re already seeing stories that warn:
"Housing Correction Worries Fed"
"Foreclosures up 24 percent in August!"
"More Fall Behind in Mortgages"

Don’t panic. That is, unless you’re one of those homebuyers who didn’t have very good credit to begin with and who desperately grabbed an adjustable rate or interest-only mortgage because you feared if you didn’t buy now prices would get so high you’d never be able to afford a home. Even if you fall into this category the picture isn’t necessarily as bleak as it sounds.

Let’s put the numbers into perspective.

One of several Internet-based Web sites that posts information about foreclosed real estate,, reports that 115,292 new properties “entered into some stage of foreclosure” in August. In nearly four out of 10 cases, this simply meant that the owners were sent a “notice of default” because they had fallen 2-3 months behind in payments (37 percent).

Just under 50 percent of the properties were in stage two, which is what everyone thinks of when they hear the word “foreclosure” — the lender has called in the sheriff’s office and an auction is scheduled (46 percent). If the property is not sold and the lender has to take ownership (17 percent), RealtyTrac considers that the final phase.

August’s overall numbers were, indeed, an increase of 24 percent over the previous month. They were also 53 percent higher than August 2005. They were even “the highest level of the year so far.”

And yet, figures compiled by both RealtyTrac (which compiles numbers on a monthly basis) and the Mortgage Bankers Association (which looks at quarterly trends) confirm that nationwide foreclosures are still slightly below their historic average. In fact, one of the reasons year-over-year comparisons look especially bleak is that default rates fell below normal for some time, thanks to interest rates that hovered at 40-year lows.

This isn’t to say there aren’t pockets where the situation is far worse. I bet the state that first comes to mind is California, which saw multiple years of double digit increases in home prices and where many of the more “exotic” mortgages were popular. (C’mon, admit it. Don’t you secretly hope Californians feel a little pain after rubbing our noses in the profits they were making by flipping homes?)

If California were your pick for first place in the foreclosure game, you’d be … wrong. In terms of sheer numbers, more homes were in foreclosure in Florida (16,533) than in California 12,506) in August. But when you look at this in terms of the total number of outstanding mortgages in each state, both drop down the list — Florida to third place and California to the twelfth place spot.

On a percentage basis, Colorado has the dubious distinction of recording the highest increase in foreclosure activity in August — up 60 percent from July. According to RealtyTrac, that works out to one home in some stage of foreclosure for every 301 households with outstanding mortgages. Much of that, however, was centered in a single city: Greeley, where the foreclosure rate is more than twice the state average and seven times the national average.

Fact is, the residential real estate market will always be more dependent on local economic conditions than other factors. It’s the reason Michigan, Ohio, Illinois, and Indiana all ended up in the top ten, ranking No. 6, No. 7, No. 8 and No. 9 respectively.

Turns out, the biggest predictor of an increase in foreclosures is an area’s unemployment rate. Makes sense: if a homeowner loses her job, she’s probably going to have a tough time making the mortgage payments. These four Midwest states have one thing in common: they’ve all been hit hard by cutbacks and plant closings in the auto industry.

Whoa! What about all those non-traditional loans that were issued, especially adjustable rate mortgages (ARMs) whose interest rates ratchet up after the low initial rate expires? Aren’t these a factor in the spike in foreclosures seen in August? After all, short-term interest rates have increased from 1 percent to 5¼ percent in the past two years.

According to Mike Fratantoni, a senior economist with the Mortgage Bankers Association (MBA), someone who took out an adjustable rate mortgage in 2003 “might have gotten a rate of 4 percent. Today, it’s more like 7½ percent. The interest rate has nearly doubled.”

RealtyTrac spokesperson Rick Sharga believes this is one factor in August's foreclosure spike. He predicts it is a trend that’s likely to continue.

“There are about a trillion dollars in adjustable rate mortgages that will adjust over the next 15 months," Sharga said. “Historically, ARMs have defaulted at a slightly higher rate than traditional mortgages.”

Furthermore, “sub-prime” mortgages — those issued to individuals with a less-than-perfect credit record — tend to have a higher default rate than “prime” mortgages — loans made to borrowers who are considered less risky.

One of the more creative adjustable rate mortgages is the “option ARM.” Each month the borrower has the choice of making: 1) the full payment of principal and interest, or 2) just the interest payment, or 3) an even smaller “minimum” payment. These are also known as “negative amortization” loans because when you make less than the full monthly payment, the underpayment is added to the principal amount.

In other words, the size of your loan gets bigger. As a result, so do the interest payments. Though the loan usually stipulates that the principal can never increase beyond a certain percentage (such as 10-15 percent), it’s easy to see how a borrower could slip into a quicksand of increasing payments he could never dig out of.

However, according to Fratantoni, only about 8 percent of the home loans issued last year were “option ARMs.” Most were issued to sophisticated individuals with excellent or “prime” credit. In all likelihood these were speculators who planned to jump into the real estate boom and get out relatively quickly after turning a handsome profit.

On the other hand, in 2005, one out of every four mortgages was some type of “interest only” loan. As the name implies, with this type of loan you only pay the interest due each month. Problem is, this doesn’t last forever. Five to seven years into the loan you also have to start re-paying principal, which significantly increases your monthly payment.

Adjustable rate and “interest-only” mortgages have been very popular among “sub-prime” borrowers. In addition to having a less-than-stellar credit rating, many of these folks are also probably stretching to buy more home than they could qualify for if they applied for a traditional mortgage. They’re betting that by the time their mortgage payment increases they’re either earning enough money to cover it or can re-finance at a lower rate.

It’s this slice of the market that is most likely to get hurt as the interest rates on these loans are adjusted upward to reflect higher market rates. Sharga points out, “Even if default rates were normal, just because there are so many of these loans, you’d see a spike” in foreclosures. In fact, according to the Mortgage Bankers’ Association, the delinquency rate on sub-prime loans is already rising faster than other categories.

Indeed, there is a growing belief that the pendulum in the housing market is swinging back to “normal.” Sales have cooled. Prices have started to drop — more in some markets than others. Fratantoni say the MBA is forecasting that, nationwide, average price appreciation will decline “from the 13 percent seen last year to single digits in 2006 and 2007.” In testimony before the Senate Banking Committee last month, National Association of Realtors president Thomas Stevens said “the housing market is undergoing a period of adjustment and becoming more and more of a balanced market between buyers and sellers.”

In what might at first appear to be an anomaly, at the same time that foreclosures jumped in August, existing homes sales were also up. This indicates there are still buyers willing to step up to the plate when some of the froth comes out of prices.

Although one or two voices, albeit loud ones, are proclaiming Chicken Little-like, “The roof is falling!,” the general consensus at this point is that there will not be a catastrophic, nationwide collapse in the residential real estate market that brings down the entire economy. Even Fed Chairman Ben Bernanke — a recent convert to obfuscation — admits “it’s very difficult to tell” how big a correction we’ll see.

Keep in mind that, although certain areas of the country are suffering from lay-offs, nationwide, the unemployment rate is less than 5 percent, well within the “full employment” range. Concern about the impact of a slowing real estate market may have literally given the Federal Reserve pause; the central bank has passed up recent opportunities to continue raising interest rates. Energy prices, which have put pressure on consumers’ budgets, have come down significantly.

The outlook at this point: Loan defaults will go up in terms of raw numbers, but the rate or percentage of foreclosures should be close to the long-term average of 1 percent.

Next week: what to do if you find yourself slipping behind in your mortgage payments.

Keep the faith,

If you have a question for Gail Buckner and the Your $ Matters column, send them to:, along with your name and phone number.